Partners in Innovation: Community Banks and Fintech Firms

This post is part of a series titled “Supervising Our Nation’s Financial Institutions."

Financial technology, or fintech, is changing how consumers and businesses bank. While digital banking options like mobile check deposit and automatic bill payment have been available for about 20 years, other services made possible by fintech—such as digital wallets and person-to-person payments—are relatively recent and are increasingly being adopted by banks of all sizes. Thus far most banks, especially community banks, have opted to partner with fintech firms to provide these services to their customers.

In response to this increase in partnerships, the Federal Reserve Board of Governors—alone and in concert with other federal banking regulators—has taken steps to document the trends observed and provide guidance for banks seeking to pursue responsible innovation.

Taking Stock of Fintech Partnerships

In the first quarter of 2021, Federal Reserve staff met with more than 40 community bankers, fintech leaders and other stakeholders to better understand the types of partnerships being formed and the perceived benefits and risks of each type. The Board recently released a white paper summarizing what staff learned (PDF) and the supervisory issues banks need to be attuned to when forming these partnerships; it does not establish new or interpret existing guidance (PDF) related to third-party risk. Based on the information gathered, the paper identifies three primary types of community bank and fintech firm partnerships:

• Operational technology partnerships
• Customer-oriented partnerships
• Front-end fintech partnerships

In an operational technology partnership, a bank adopts technology provided by a fintech firm to improve its internal processes, monitoring capabilities or technical infrastructure. The technology may assist with streamlining or automating existing processes, such as loan origination, saving the bank time and resources. Technology may also aid regulatory compliance with “know your customer” and anti-money laundering rules if it is used to improve fraud detection and customer authentication. These types of applications aim to reduce the potential for error, create efficiencies, reduce costs and allow resources to be reallocated to other bank functions.

Whereas an operational technology partnership is focused on improvements to the back-office aspects of banking, a customer-oriented partnership seeks to improve bank functions that customers can observe, such as opening accounts or making deposits. A fintech partner may assist a bank in integrating applications that simplify person-to-person payments, for example. More generally, these partnerships can extend a bank’s reach, eliminating the need for physical locations or making it easier to gather deposits over a wider area. These relationships paid off during the pandemic-induced economic shutdown. Banks participating in the Paycheck Protection Program were able to use application modules developed by a fintech firm or a core provider, making it easier for loan applicants. Other banks—with the help of fintech—started providing teller video chat, making it easier for customers to conduct business during branch closures.

The most integrated but least common type of partnership has been dubbed the front-end fintech partnership, sometimes called Banking-as-a-Service (or BaaS). In these partnerships, a fintech firm interacts directly with bank customers as they make deposits, take out loans or engage in other banking activities. Proponents of this model tout the ability to reach customers the bank alone could not, but there are more third-party risks too. Errors made by the fintech firm could hurt the bank’s reputation since customers would view the fintech firm and bank as one entity. Outside firms may not be aware of all the regulations banks must comply with and the supervision that accompanies them, making third-party risk management especially important with these types of arrangements.

Other Actions by Bank Regulators

The publication of the white paper is part of a series of actions taken by bank regulators in response to the growth in these partnerships. In August, the Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency released a guide outlining due diligence considerations (PDF)—such as a fintech’s business experience and qualifications and its relevant legal and regulatory compliance—for community banks seeking these partnerships. As part of the examination process, banks are evaluated on how well they manage safety and soundness and consumer protection risks associated with third-party relationships.

The above agencies also put out for comment risk-management guidance for banks in relationships with third-party providers (PDF), including fintech firms. The proposed guidance lays out expectations for various aspects of third-party relationships, including planning, due diligence and third-party selection, contract negotiation, oversight and accountability, ongoing monitoring, and termination. Comments closed in mid-October; it’s unclear at this point when the final guidance will be released.

Responsible Innovation Is Important

Technological advancements, consumer demand and pandemic-related business disruptions have prompted an acceleration in innovation among the nation’s banks, including community banks. There are significant advantages in terms of potential cost reduction and access to expertise for banks that seek to work with fintech firms to reduce overhead and broaden their offerings to consumers. But as Federal Reserve Gov. Michelle Bowman noted in a September 2021 speech, it’s important that banks selecting fintech partners ensure there is alignment in values and a mutual emphasis on collaboration. Before going forward, bankers should have a solid understanding of the problem that would be solved with a partnership and be sure there is buy-in from their bank’s senior management and board of directors.